Chapter 10: Other Financial Products

Question 1

What are the 3 ways individuals can borrow money from banks and other lenders?

Answer 1

• Overdrafts
• Credit card borrowing
• Loans

Question 2

What is an Overdraft?

Answer 2

When an individual draws out more money than they hold in their current account.

Question 3

What is an ‘authorised’ overdraft?

Answer 3

If amount overdrawn is within the limit previously agreed with the bank.

Question 4

What is an ‘unauthorised’ overdraft?

Answer 4

If amount overdrawn exceeds the agreed limit, or if it’s not been previously agreed.

Question 5

What are the fees of ‘authorised’ overdrafts?

Answer 5

Agreed in advance so usually have lower rates of interest. Some banks allow small overdrafts with no fees to prevent angry customers.

Question 6

What are the fees of ‘unauthorised’ overdrafts?

Answer 6

Often very expensive - high interest and a fee. Bank may refuse to honour payments from unauthorised overdrawn account.

Question 7

Are overdrafts a good way to borrow money?

Answer 7

• Expensive
• Borrowers should restrict use to temporary periods
• Avoid unauthorised overdrafts.

Question 8

Where are Credit Cards most commonly used?

Answer 8

UK, not so much in the rest of Europe.

Question 9

What can be purchased using credit cards?

Answer 9

Retail goods, e.g. food, electrical goods, petrol, cinema tickets.

Question 10

How do retailers get paid by the credit card company’s for goods sold?

Answer 10

Credit card company charges retailer a % fee, but this enables the store to sell goods to customers using their credit cards.

Question 11

How do customers pay off credit cards?

Answer 11

• Customers sent monthly statement by credit card company.
• Then choose to pay all or a % of total money owed.
• Interest is charged on balance owed by customer.

Question 12

Is interest high on credit cards?

Answer 12

Yes, compared to other forms of borrowing.

Question 13

When might a customer not pay interest?

Answer 13

*If they pay their total balance at the end of each month.
* 0% interest card to new customers for balances transferred from other cards and for new purchases for a set period (offers usually only available if a fees is paid).

Question 14

What 2 groups can Loans be divided into?

Answer 14

• Secured loans
• Unsecured loans

Question 15

What is an Unsecured loan?

Answer 15

Loan not linked to the item that’s purchased with the loan.

Question 16

What happens if the lender is not repaid on an unsecured loan?

Answer 16

If borrower defaults it can be difficult for the lender to enforce repayment (usually enforced by legal proceedings).

Question 17

What happens if secured loans are not repaid?

Answer 17

Lender can repossess the specific property which was the security for the loan.

Question 18

What are unsecured loans typically used to purchase?

Answer 18

Consumer goods.

Question 19

What do lenders assess when deciding to offer out a loan?

Answer 19

Creditworthiness of borrower?

Question 20

What do lenders assess when deciding to offer out a loan?

Answer 20

Creditworthiness of borrower - assessing whether they can afford to repay the loan and interest over the agreed term of, say, 48 months from their income given their existing outgoings.

Question 21

What is an example of a secured loan? What’s the interest rate like?

Answer 21

Mortgages provide security as the lender can repossess the house if not repaid. Means rate of interest is likely to be lower than other forms of borrowing.

Question 22

What is a Commercial Loan?

Answer 22

Used to fund major capital expenditure by a company and/or cover operational costs that the company cannot immediately meet.

Question 23

What are characteristics of commercial loans?

Answer 23

• Lender assesses creditworthiness.
• Various lengths of time.
• Variable or fixed interest.
• Commercial mortgages for commercial property.

Question 24

What influences the cost of borrowing?

Answer 24

varies depending on:
* Form of borrowing
* How long the money is required for
* Security offered
* Amount offered

Question 25

What do borrowers often have to grapple with?

Answer 25

Different rates quoted by lenders; loan companies traditionally quote flat rates lower than the true rate or effective annual rate.

Question 26

What’s the formula for effective annual rate?

Answer 26

Quoted rate / 4 (represents quarterly charge)

Question 27

To make comparisons easier, what must lenders quote?

Answer 27

Quote true cost of borrowing, embracing the effective annual rate and including any fees that are required to be paid by the borrower (this is APR).

Question 28

What are some characteristics of the property market?

Answer 28

• Proportion of families who own or buying homes is higher than anywhere in the EU.
• In past, ownership been encouraged, e.g. tax relief on mortgage interest payments, or buying council homes.
• People take second mortgages to buy holiday homes or ‘buy-to-let’.
• Each property is unique.

Question 29

Is property a good investment?

Answer 29

Yes
* Past performance on property prices.
* Any capital gains made on home aren’t subject to capital gains tax (but any on second are).

Question 30

What’s a disadvantage of property?

Answer 30

Cost of purchase is substantial, embracing solicitor’s fees and stamp duty.

Question 31

What is a Mortgage?

Answer 31

Secured loan with the security taking form of a property.

Question 32

What are characteristics of a mortgage?

Answer 32

• Provide finance for property.
• Long-term loan (20-25yrs).
• Rising house prices means mortgage terms increased (40% have terms over 25yrs and half of that is 30yrs).

Question 33

What does mortgage lender look at when giving a loan?

Answer 33

Credit risk - risk of not being repaid the principal sim loaned and the interest due.

Question 34

What are mortgage applicants assessed in terms of?

Answer 34

• Loan-to-income ratio
• Existing outgoings
• Future problems
• Loan-to-value ratio

Question 35

What is the loan-to-value ratio?

Answer 35

Size of loan in relation to the value of property being purchased

Question 36

What is the loan-to-income ratio?

Answer 36

Amount borrowed based on multiple of applicants income - capped at 4.5x their income.

Question 37

What existing outgoing might affect the applicants application?

Answer 37

Utility bills, household expenses, school fees. Lender undertakes an affordability assessment to assess whether applicant can afford monthly repayments.

Question 38

What future problems might affect the applicants application?

Answer 38

Stress test applicant’s ability to repay mortgage taking into account possible changes to lifestyle, e.g. redundancy, starting a new family, children, career break.

Question 39

Can 2 mortgages be taken out on one property?

Answer 39

Yes. If a borrower defaults on their borrowings, the 1st mortgage ranks ahead of 2nd in terms of being repaid out of proceeds of property sale.

Question 40

What are the 4 methods by which interest may be charged?

Answer 40

• Variable rate
• Fixed rate
• Capped rate
• Tracker rate

Question 41

What’s a Variable rate mortgage?

Answer 41

Borrower pays interest rate at a rate that varies with prevailing interest rates - lenders standard rates reflect increases or decreases in rates set by BoE.

Question 42

What are the pros and cons of variable rates for borrowers?

Answer 42

Benefit when rates fall, but suffer when rates hike.

Question 43

What is a Fixed rate mortgage?

Answer 43

Borrowers interest rate is set for an initial period, e.g. first two or five years.

Question 44

What are the pros and cons of fixed rate mortgages?

Answer 44

If interest rises, borrowers pay the lower fixed rate of interest. If interest is lower, you’re stuck paying the higher rate.

Question 45

What happens when you cancel a fixed-rate loan?

Answer 45

Fixed-rate loan can only be cancelled if a redemption penalty is paid. Penalty is calculated to recoup the loss suffered by the lender as a result of cancellation if fixed-rate loan. It’s common for fixed-rate borrowers to be required to remain the lender and pay interest at the lender’s standard variable rate for a couple of years after the fixed-rate deal ends - commonly referred to as a ‘lock-in’ period.

Question 46

What’s a Capped mortgage?

Answer 46

Protect borrowers from rates rising above a particular rate - ‘capped rate’. e.g. mortgage take out at 3% but capped at 4%. If rate falls to 2%, borrower pays at that rate, but if it rises to 5% the paid rate has to be 4% (as its the cap).

Question 47

What’s a Tracker mortgage?

Answer 47

Mortgage that’s linked to another rate such as the BoE base rate. Tracker will be set at a % above the BoE base rate, say 1% above, and will then increase or decrease as base rate changes.

Question 48

What’s a Discounted rate mortgage?

Answer 48

Lending institutions attract borrowers by offering discounted rate mortgages - e.g. 3% loan might be discounted to 2% for first 3 years.

Question 49

What’s a Repayment mortgage?

Answer 49

Most straightforward - mortgage in which borrower will make monthly payments to the lender, with each monthly payment comprising both interest and capital.

Question 50

What’s the key advantage of a repayment mortgage over other forms of mortgage?

Answer 50

As long as the borrower meets the repayments each month, they’re guaranteed to pay off the loan over the term of the mortgage.

Question 51

What are the main risks attached to a repayment mortgage (borrowers perspective)?

Answer 51

• Cost of servicing loan could increase, when interest is charged at the lender’s standard variable rate of interest. This rate of interest will increase if interest rates go up. Mortgage repayments can rise significantly at the end of a fixed-rate deal when they revert to the standard variable rate.
• The borrower runs the risk of having the property repossessed if they fail to meet the repayments - mortgage loan is secured on the underlying property.

Question 52

What are Interest-Only mortgages?

Answer 52

Requires borrower to make interest payments to the lender throughout the period of the loan. At the same time, the borrower generally puts money aside each month, into some form of investment.

Question 53

What’s the borrowers aim for an interest only mortgage?

Answer 53

For investment to grow through regular contributions and investment returns (such as dividends, interest and capital growth) so that at the end of the mortgage the accumulated investment is sufficient to pay back the capital borrowed and perhaps offer some additional cash.

Question 54

What are the main risks attached to an interest-only mortgage from the borrower’s perspective?

Answer 54

• Borrowers with interest-only mortgages still face risks that repayment mortgage borrowers face - namely that interest rates may increase and their property is at risk if they fail to keep up the payments to the lender.
• Additional risk that investment might not grow sufficiently to pay the amount owing on the mortgage. In the example above, there’s nothing guaranteeing that at the end of the 25 yr term, the investment in the fund will be worth £100,000.

Question 55

What is an Offset mortgage?

Answer 55

For the calculation and charging of interest, any mortgage is offset against, e.g., any savings you may hold.

Question 56

What are the 2 main benefits of offset mortgages?

Answer 56

• Higher-rate tax payer will not incur tax on any savings interest earned because it has been offset against the mortgage borrowing.
• As interest is being paid on a slightly lower mortgage, it provides some flexibility to manage finances, pay off the mortgage a little quicker and have more control.

Question 57

What’s Life Assurance?

Answer 57

A life policy is an insurance policy in which the event insured is a death. They involve the payment of premiums in exchange for life cover - a lump sum payable upon death.

Question 58

What does the total paid out depend on?

Answer 58

• Depends on the guaranteed sum
• Date of death
• Investment performance of the fund

Question 59

Why does the total paid out depend on these factors?

Answer 59

Instead of paying a fixed sum on death, there are investment-based policies which may pay a sum calculated as a guaranteed amount + any profits made during the period between the policy being taken out and the death of the insured.

Question 60

What are the 2 types of life cover?

Answer 60

• Whole-of-life assurance
• Term assurance

Question 61

What’s the difference between whole-of-life assurance and term assurance?

Answer 61

Whole-of-life policy provides permanent cover, meaning that the sum assured will be paid whenever death occurs, as opposed to if death occurs within the term of a term assurance policy.

Question 62

What are the 3 types of whole-of-life policy?

Answer 62

• Non-profit - for a guaranteed sum only.
• With-profits - pays a guaranteed amount plus any profits made during the period between the policy being taken out and death
• Unit-linked policies - in which return will be directly related to the investment performance of the units in the insurance company’s fund.

Question 63

What’s the reason for such policies being taken out?

Answer 63

Are usually bought as part of a protection planning exercise to provide a lump sum in the event of death to pay off the principal in a mortgage or to provide funds to assist with the payment of any tax that might become payable on death. They can serve two purposes, therefore, both protection and investment.

Question 64

What is life assurance?

Answer 64

Type of policy that pays out a lump sum in the event of death occurring within a specific period.

Question 65

What uses does the term assurance have?

Answer 65

• Ensures there are funds available to repay a mortgage in case someone dies.
• Providing a lump sum that can be used to generate income for a surviving partner.
• Provide funds to pay any tax that might become payable on death.

Question 66

What happens when taking out life cover?

Answer 66

• Individual selects the amount they wish to be paid out if the event happens and the period that they want to cover to run for and whether the required cover is level, increasing or decreasing.
• If, during the period when cover is in place, they die, then a lump sum will be paid out that equals the amount of life cover selected.
• With some policies, if an individual is diagnosed as suffering from a terminal illness which is expected to cause death within 12 months of the diagnosis, the the lump sum is payable at that point.